The last three years have been good to investors in developed market equities. Since the 2011 market bottom in the depths of the European financial crisis, the MSCI World index has advanced 66.8% on a cumulative basis, with some of the strongest results in the U.S., where the S&P 500 index has gained 84.1%. Although company fundamentals (earnings, cash flow, etc.) were supportive of an increase in valuations, some investors are concerned that stock prices may have come too far, too fast, and are worried that a correction may be in the offing. Because the U.S. stock performance has been so strong, investors are fearing downside to stocks and value stocks in particular. Some high-flying growth stocks have already suffered. In this context we have examined the history of value stock performance when markets sell off, asking the question:
Pzena: Do value stocks protect in market corrections?
For this study we are focused on the U.S. as it provides a long history with multiple cycles and allows us to clearly identify recessions and other events. It should be noted that other markets, particularly Emerging Markets, are lagging the U.S. and at a different stage of the cycle today.
We examined fifty-four years of monthly returns in the U.S. going back to 1960, focusing on performance of the S&P 500 index and value stocks1 during market declines of 10% or greater, which we term “market corrections.” The data suggest that there are patterns as to when value stocks outperform and underperform during market corrections that are traceable to excessive valuations, recessions and financial crises.
Pzena: The Results
There were fourteen market corrections, with value outperforming in nine of those periods and underperforming in five (Figure 1) with an average outperformance of 1.4%. Given that track record, one might conclude that value stocks should be expected to outperform, or “protect,” almost two-thirds of the time during market corrections.
A deeper examination of the data produces additional information about when value stocks provided protection during a correction. The key factor appears to be the nature of the trigger behind the market correction. In general, there were three types of triggers we identified:
- Financial crises, and
- Valuation corrections not associated with either a recession or financial crisis.
Recessions alone or corrections driven by excessive valuations absent a financial crisis appear to favor value stocks, which outperformed in nine out of ten of these periods by an average of 6.8%. One of the most dramatic of these periods was the bursting of the internet bubble which started in March, 2000. During the subsequent thirty-five months, value stocks went on to outperform the S&P 500 index by 14.1%, as the massive overvaluation of “new economy” stocks unwound. Although the magnitude of value’s outperformance was smaller during the stock market crash of 1987, this sudden adjustment in valuations saw value stocks outperform by 7.9%. Four other periods associated with economic recessions but no financial crises also saw value stocks outperform.
Of the five periods of underperformance, four were associated with financial crises. This included the Global Financial Crisis of 2008/09, European “echo” crisis of 2011, the Asian currency crisis of 1998, and the U.S. Savings & Loan crisis of 1990/91. Although the 1968-70 correction, where value stocks underperformed, included the Penn Central bankruptcy (the largest such event in U.S. history to that date), we have not included it in the financial crisis category.
The history of value in periods following market corrections is one predominantly of outperformance, in many cases by a significant margin. During our study period, value outperformed in thirteen of fourteen periods post-correction (Figure 1), leading to value stocks adding almost 2.5% per annum of excess return over the S&P 500 for the entire fifty-four year period.
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